On the 2nd September Thorndon hosted a roundtable discussion involving a number of client NEDs from the Guernsey fund industry.
This paper summarises the conversation and highlights some of the conclusions and actions that arose out of it. At the centre of the discussion was the recognition of the importance in the face of ever-increasing governance risk for NEDs and indeed, all directors, protect their own personal assets, income and, reputation.
The D&O Insurance Market
Traditionally at the centre of risk management and mitigation of NEDs has been the D&O insurance purchased to their benefit by the fund. It is well documented that the conventional insurance market for this cover has been changing rapidly in recent times and the first part of the event discussed the latest market developments.
Increasing premiums, lower limits, more restrictive cover
These trends have been accelerating due to a combination of factors including:
- Shrinking market capital and, hence, capacity
- Increasing regulatory capital requirements
- Sustained low investment returns
- Increasing claims and the perception of increasing risks
- Increasing margins on other lines of business increasing competition for capacity
- Demand > supply across many classes, especially professional risk
These basic market trends have exposed other issues in the supply chain for D&O.
A lot of insurance is provided via broker facilities based on standard terms being supported by underwriters. Many of these arrangements have sustained for some time but brokers now are facing real challenges in retaining capacity from existing suppliers and even more so in attracting new capacity where needed. Even where underwriters continue to support the facilities, they are often substantially reducing their exposure.
It is some time since the insurance market made such a concerted effort to increase rates and toughen up on terms. The last significant hard market cycle was in the 1980s. This means that many involved, both brokers and underwriters, have limited experience of trading in such a market.
This makes the scrutinising and monitoring of brokers and the insurance they negotiate more critical than ever before.
It also raises the potential value and burden of retentions and deductibles where these can be accommodated, in other words the costs and benefits of retaining risk on your own personal balance sheet.
For Guernsey there are additional factors affecting the willingness of underwriters to provide cover. These include the commercial viability of providing insurance for sophisticated and complex risks in what for them is a low volume market, especially given improved margins available on less complex and risky risks elsewhere. There are also real and justifiable concerns over the cost of legal advice and support in the Bailiwick when compared directly with more specifically expert and specialist advisers in London.
A number of potential responses to this were considered, including the use of voluntary deductibles and risk differentiation. However, it was noted that the supply chain was not helpful, (see below) and that underwriters often had limited authority to go outside prescribed terms and rates.
D&O Supply Chain
The supply chain seeks to produce a high quality understanding and agreement between the board and the underwriter, each of whom has excellent understanding of their own area of responsibility but whose understanding of each other is via communications through the fund administrator and broker as follows:
Thorndon’s negotiating model below seeks to develop a more direct and informed dialogue creating better understanding, better cover and better terms for both underwriter and board.
Intermediaries in the supply chain are hampered by their own limited understanding and knowledge of the ultimate contracting parties and by issues on conflicts of interest such as:
- Administrator by the interests of their own organisation and any representative directors
- Broker by the scale requirements and particulars of their commercial relationship with the underwriter
D&O Insurance
A number of potential issues were raised regarding the nature of D&O insurance itself and its function in protecting directors.
Barriers to Indemnity and Access Difficulties
It was noted that directors can experience problems accessing cover, especially where they have already left the board.
In recent years policy wordings have developed and improved. However, poor practice remains and coverage is often poorly documented. Confusing and ambiguous contract wording still exists and provides ample opportunity for coverage to be disputed at the very point of delivery – i.e. when a claim arises. To discover such issues at the point of claim simply adds stress on NEDs at the very moment when the policy should be providing support and relief.
This is not helped by the mixed performance of broker claims teams. Given the incentive regimes of brokers, claims servicing does not attract the best talent in the industry. In addition, it is noticeable that the commercial relationship between broker and insurer is generally substantially greater than that between broker and client. This conflict is further evidenced by the disclosure by brokers themselves that they are agents of the insurers as well as of their clients. In such circumstances it is hard to see brokers as being completely on the side of the NEDs.
It is worth noting also that the broker is appointed and paid by the company not the directors. This should also give additional pause for thought to NEDs relying on them to look after their interests come claims time.
Most committed claims professionals work on the insurer side and are very much focused on the resolution of claims to the best advantage of the insurer rather than the client. For NEDs this can leave them with no professional claims support that is truly aligned with and committed to their own personal interests. In such circumstances, independent expert support is essential.
Ownership
The policy is a contract between the company and the insurer. Whilst the directors are beneficiaries, they are not parties to it. Hence the underwriter’s obligation is to the company not the NED.
Similarly, the broker relationship is also with the company rather than the NED.
In circumstances where the interests of the company and the NED diverge, or in the event of the company going bust, this leaves the NED potentially exposed, particularly when it comes to claims time.
Limits of Cover
With market capacity shrinking and group cover becoming increasingly popular there are significant concerns regarding the allocation of cover amongst the various boards and directors within the scope of the policy. Insurers will treat claims in the order presented and aggregate cover will be eroded by claims as they are paid. It follows that if your claim is later advised than others there is a possibility
Beware of sub-limits
Policies will often prescribe sub-limits in respect of specific risks. These may or may not be relevant and may or may not be adequate. We have seen policy sub-limits in respect of the costs of defending extradition proceedings of £50,000. In the event of such proceedings being brought by the USA such a limit would be wholly and completely inadequate. Where a fund has US investors or assets, or even transacts in USD such an event is not beyond realistic possibility.
Other coverage issues
Obligations and duties of directors are constantly changing, and D&O coverage needs to evolve to keep pace. Annual independent review is crucial to ensure fit-for-purpose insurance. Whilst some boards may have sufficient expertise in-house to undertake this, most will not.
Most coverage centres on traditional sources of claims (i.e. civil litigation by shareholders, employees and others). However, regulatory obligations and exposure coupled with increasingly aggressive regulators and the increasing focus on individual directors as the target of regulatory enforcement action is making funds and financial services generally particularly risky. These claims are much harder and more complex to defend and involve issue beyond financial settlement such as NEDs’ reputations and continuing ability to trade.
An example of new obligations is the requirement for directors in Guernsey to sign off on substance statements as part of the tax return. These are likely to be covered but it pays to be sure.
Company Indemnities
Company indemnities are an important part of the overall risk mitigation and financing for NEDs. However, attitudes towards them varied significantly amongst those present with some very happy to rely on such commitments based on their own experience of them being honoured, clear documentation of the commitment, and the ability of their fellow directors to ensure that such commitments are met in full. Others were less certain of the reliability of such arrangements based on situations in which experience was lacking and documentation poor.
As a result it was noted that all such arrangements should be as widely and prescriptively documented as possible, especially where relied upon by retiring directors.
It was noted that the obligations of companies to NEDs do not cease either with their departure or with the company becoming insolvent. However, it was noted that the courts would be unlikely to allow preference to be shown to a former director over other creditors.
The practice of liquidators cancelling D&O cover in the event of insolvency was discussed. Amongst lawyers present it was regarded that any specific obligation to maintain D&O cover to their benefit would still be in force even after their removal during insolvency proceedings provided there was a clear contractual obligation on the company to do so.
Runoff Period
Following departure, directors will have exposure for a further 6 years and even longer in respect of certain circumstances. It follows that consideration be given to ensuring adequate protection post-service for at least that six year period.
Firstly the agreement terminating the appointment should include specific references to the continuation of all indemnity obligations on the part of the company for at least 6 years after the date of termination. Similarly the company should be required to ensure continuing D&O cover for the same period as a named beneficiary under the policy. Annual confirmation of the renewal of D&O cover and current claims contacts should be sought each year. Again the provision of this should be included in the termination letter.
In addition the purchase of personal D&O cover to include retired positions (as a routine purchase – not when you think you might need it!) is advisable although does obviously carry some costs.
Claims time
Our experience in recent years has highlighted a number of issues that have arisen right at the wrong time.
Insurers
Insurer responses are variable. Whilst many people pay attention to the financial rating of insurers, few are aware of the service quality assessments that are available. Nor do they tend to seek endorsement from policyholders with experience of the insurer in respect of claims. This is not unheard of in insurance. The NFU are very keen to introduce policyholders to prospective new clients as they are confident of the positive endorsement they will receive.
Case management
Guernsey case management costs (and legal fees in general!) are high by comparison with UK comparators. Furthermore having case management undertaken by local advocate firms restricts continuity in the event that a change in local legal advisers becomes necessary. Independent case management can alleviate both issues significantly.
Claim administration
Brokers’ claims services are often poor and provide limited value. Whilst policies often prescribe policy access via the broker the use of an independent claims advocate to oversee the process and undertake important discussions and negotiation with the underwriter is advisable.
Impact on personal and professional life
The impact of a protracted investigation and enforcement or litigation process will impact on a NEDs private life to a very substantial extent. Having independent personal support focused solely upon your own objectives and interests is important to help mitigate the stress involved.
Risk Mitigation
Risk management
We have mentioned above about the need for good documentation of insurance and indemnity arrangements. However, there are a number of other key areas where risks are assuaged through layers of risk management and insurance.
Governance risk management has developed in response to developing accountability and risks as they have emerged.
The need for greater board accountability to shareholders and others is met by governance processes and record keeping overseen by the company secretary. In recent years these have become increasingly bound up in the evidencing of prescriptive compliance with regulation, reflecting the increasing risks arising out of the growing regulatory burden faced by modern boards.
To meet these growing challenges, boards now rely not only on the Company Secretary but also on a range of compliance officers whose job it is to ensure that the company not only is compliant but is seen to be so across areas such as regulatory compliance, AML, tax, and so on.
D&O has for many years provided the ultimate fallback to any issue arising out of governance and compliance. However, as the source and range of risks increases in both extent and complexity, relying on internal processes and external insurance is increasingly and inherently insecure to the directors at the sharp end of scrutiny and responsibility.
Risk avoidance
Equally it is important for the directors to avoid providing indemnity to service providers, advisers and other commercial counterparties – wronged parties will go after everyone involved and where advisers are involved their own PI insurance should be invoked, not an indemnity clause bouncing their responsibility back to their client. In addition, the board should ensure that all such counterparties have adequate levels of PI cover in place.
External independent advice
As in other areas of strategic risk taking, it is important to seek to supplement the capabilities and expertise of the board with additional external, independent expertise, and to enhance external insurance arrangements with robust internal indemnity supported by specific financing arrangements as GAP cover for D&O and to meet any uninsured elements of company indemnity commitments to NEDs.
High quality advice will enable a board to make informed decisions based on an holistic understanding the risks faced and the various measures in place to mitigate, manage and finance it.
Proper and adequate risk protection for directors in relation to their own personal and collective governance risks frees them up to focus on the interests they are supposed to represent and enhances the governance process to the benefits of the company and its stakeholders.
